E-259
RM2-13.0
10/10
Risk Management
Using Options to Hedge Farm and Ranch Inputs
David Anderson, Dean McCorkle, Mark Welch, Daniel Hanselka and Daniel O’Brien*
Call options are a pricing tool that gives
producers considerable flexibility in managing
the price risks associated with farm and ranch
inputs. The main advantages of a call option are
protection against higher prices, limited liability with no margin deposits, and the potential
to benefit from lower cash prices. Futures contracts alone cannot provide this combination of
upside price insurance and downside potential.
The call provides leverage in obtaining credit,
assists in procurement decisions, and has a
formal set of contract provisions and known
procedures for settling disputes. The option
premium cost is paid at the time of purchase
and basis risk remains until fixed or the commodity is acquired. Each option represents
a standardized quantity linked to a futures contract, and trades must go through a commodity
broker.
This publication describes hedging the costs
of inputs with options. The reader should
understand the basics of futures, options and
basis prior to reading this publication. This
information can be found in the following publications in this series: Introduction to Options
(E-499), Factors Affecting Option Premium Values
(E-577), Selling Hedge with Futures (E-497), Buying
Hedge with Futures (E-498), Knowing and Managing Grain Basis (E-575), and Hedging with a Put
Option (L-5250).
Using Call Options for Price Protection
Buyers of call options can hedge their upside
price risk for a period of time and still benefit
from price declines if the market should fall.
An option is much like an insurance policy. The
purchaser pays a premium to protect against a
possible loss. Once the premium is paid, the call
buyer has no further obligation.
The strike price/market price relationship
can be in-the-money, at-the-money, or out-of-the
money. A call option is in-the-money when the
futures price exceeds the strike price. It is outof-the money when the futures price is below
the strike price. When the strike price equals the
current market price of the underlying futures, it
is at-the-money. Depending on price movements,
you can either accept or leave the guaranteed
price. That is, if the futures price moves lower
after you buy the option, you can walk away and
forget about the option. But if the market goes up,
you have the price protection with the call option
at the selected strike price. Figure 1 illustrates
how the price ceiling is derived.
+
+
+
Strike price
Call premium paid
Local basis (may be negative)
Brokerage fee/transaction costs = Price ceiling
Figure 1. Price ceiling with a call option.
*Professor and Extension Economist–Livestock and Food Products Marketing, Extension Program
Specialist III–Economic Accountability, Assistant Professor and Extension Economist–Grain
Marketing, Extension Associate–Economic Accountability, The Texas A&M System; and Extension
Agricultural Economist, Kansas State University Agricultural Experiment Station and Cooperative
Extension Service.
After the buyer has purchased an option from
the option seller (writer), the option contract may
be handled in any of three ways:
Protecting Input Prices
with a Call Option
To illustrate the use of a call option, assume a
dairy producer is thinking about buying a call
option on corn to protect his feed costs for next
spring. He uses about 200,000 pounds of corn per
month and would like to hedge enough corn to
cover both February and March (400,000 pounds
or 7,142 bushels). His corn price objective is $5.20
or less. It is August now, and the CBT March Corn
futures contract is trading at $4.87 per bushel.
Believing that corn futures will rise between now
and next spring, he buys one at-the-money call
option with a strike price of $4.90. The premium
costs $0.45 and the 3-year average March corn
basis in his area is -$0.10. The purchase of a call
option establishes a price ceiling, subject to basis
risk, of $5.25 ($4.90 strike + $.45 premium + -$0.10
basis) for corn purchased next February. This is
just above his price goal of $5.20. The producer
feels that the slightly higher hedged price (price
ceiling) with the call option is more desirable than
the risk of being unhedged when prices might
increase in the future. Remember that the basis is
not locked in (in this example) and it could end up
being weaker or stronger than the -$0.10.
Let the call expire. The buyer of a call may let
the option expire if the futures price has decreased and the option value has completely
eroded. In other words, he may do nothing if
the option has no value at its expiration date.
Thus, the option premium paid becomes another production/marketing expense. However, the
option protected the buyer against rising prices
for a period of time. The option seller keeps the
premium.
Offset the call option. The call option buyer
may decide to make an offsetting transaction in
the options market if the option has increased
in value or part of the premium can be salvaged.
The offset transaction is accomplished by the
buyer selling the call option on the exchange.
Profit or loss depends on the current market
price (premium) of the option compared to the
original price paid. The buyer can offset the option at the current market premium at any time
until the expiration date.
Exercise the call option. The call buyer may exercise the right under the option contract, on or
before the expiration date, to take a buy (long)
position on the futures market at the strike price
associated with the options contract. The option seller is required to take the short side and
keeps the premium the buyer paid. The option
buyer acquires the futures position and becomes
subject to margin requirements. Producers
would rarely exercise an option except under
certain favorable market conditions.
Table 1 illustrates the range of possible net
prices (cash price + gain/loss on the option) the
dairy producer could pay for corn, depending on
what futures prices do between the date the call
option was bought and the date the hedge is lifted
in February (at expiration).
Table 1. Sensitivity table for the $4.90 call option
hedge.
Call Option Delivery Months
Futures
price
When buying a call option (or put option), you
select the appropriate delivery month. While an
option has the same delivery month as the underlying futures contract, the option usually expires
in the latter part of the month preceding the delivery month. For example, the December corn option
expires in late November, March corn options
expire in February, and so on. Chicago Mercantile
Exchange (CME) Live Cattle and Live Hog options
expire in the month prior to the corresponding
futures delivery month. However, Feeder Cattle
options expire on the same day as their corresponding futures contract.
Cash price1
Gain/(loss)
on call
Net price
paid2
$4.60
$4.50
($0.45)
$4.95
$4.70
$4.60
($0.45)
$5.05
$4.80
$4.70
($0.45)
$5.15
$4.90
$4.80
($0.45)
$5.25
$5.00
$4.90
($0.35)
$5.25
$5.10
$5.00
($0.25)
$5.25
-$0.10 basis
Does not include brokerage fees or interest
1
2
2
From Table 1 the $5.25 price ceiling is evident
for all futures prices above the $4.90 strike price.
For futures prices above the strike price, higher
cash prices are offset by gains in the value of the
call option.
Price ceiling
Call strike price
+ Call option premium
- Put option premium
+ Local basis (may be negative)
For any futures price equal to or lower than
the strike price, the dairy producer lets the option
expire having no value. The call option is worthless because it has a loss built into it equal to the
difference between the futures price and the strike
price. Consider a closing futures price of $4.80. It
stands to reason that no one is going to pay for the
right to buy a futures contract at a higher price
($4.90) and have an immediate loss in the position.
As a result, the out-of-the-money option is worthless at expiration. In this case, the option expires
having no value and the buyer forfeits the premium paid for the option.
= Window price ceiling
Floor price
Put strike price
+ Call option premium
- Put option premium
+ Local basis (may be negative)
= Window floor price
Figure 2. Price ceiling and floor price with a window.
Margin Money
for Writing Put Options
One of the keys to hedging is knowing your
basis. Historical basis data for your area is vital
to implementing a hedge that meets your needs.
Basis does fluctuate, but usually follows a seasonal
trend throughout the year. It is advisable to allow
room in your pre-hedge analysis for the actual
basis to deviate from your estimate.
A word of caution is needed at this point. The
writing (selling) of a put option requires that a
margin account be maintained because the option
writer (seller) must maintain equity in his/her position. Option premiums fluctuate based on market
conditions. Margin calls are based on the change in
the value of the call option premium. For example,
assume you sell (write) the out-of-the-money corn
put option above: futures are trading at $4.90, you
sell a $4.70 put at $0.38. A few weeks later, the price
of corn drops to $4.70, causing the option premium
value to increase to $0.50. The value of your margin
account is reduced by $0.12 per bushel. A margin
call is issued if this loss puts your account balance
below the maintenance margin level. For more
information on margin accounts related to writing
call options, please refer to Introduction to Options
(E-499).
Creating a Window
to Reduce Premium Cost
A problem that often arises with buying a call
option is that the option premium is higher than
you can justify. One hedging strategy that sets a
price ceiling and allows for limited downside price
potential while also reducing option premium
costs is referred to as a window (or fence).
A window strategy for protecting the cost of
farm and ranch inputs involves simultaneously
buying a call option and selling a put option.
Because you can choose whichever strike prices
you desire (from among the strikes offered), the
window strategy can be customized to best fit your
situation. For example, you can choose strike prices
so that the premium received from the put option
totally offsets the cost of the call option, establishes
a price ceiling that at least allows you to have a
positive cash flow, or any other possible objective
you may want to achieve with your window strategy. The window, or the range between the price
ceiling and the floor price, is determined by these
two strike prices. The price ceiling and floor price
for a window strategy are detailed in Figure 2.
Call option sellers should also be aware of the
possibility of being exercised upon. If the futures
price is below the put strike price at expiration, the
buyer of the put option has incentive to exercise the
put option. If the option holder (the buyer) chooses
to do so, the option seller (you in this case) could be
placed in a long position at the strike price, which
would likely result in a loss for the put option seller.
Keep in mind that any loss on the put option,
which is paid through margin calls, will be roughly
offset later by a lower cash price paid when the
commodity is bought. But, a short-term cash flow
problem could arise.
3
Window Strategy Illustration
Using the same example as above, the dairy
producer feels the $0.45 call option premium is
too expensive for the protection afforded and is
considering simultaneously selling (writing) a
put option to offset a portion of the call premium.
After reviewing the put and call option strike
prices and current premiums, and analyzing the
various floor and ceiling prices associated with
several different combinations of strike prices, he
decides to purchase a $4.90 March call option for
$0.45 and sell a $4.70 March put option for $0.38.
This creates a price ceiling of $4.87 and a floor
price of $4.67 (Table 2).
Table 3. Estimated results of window strategy for
farm/ranch inputs.
Buy a $4.90 call for $0.45—Sell a $4.70 put for $0.38
Table 2. Window strategy ceiling and floor price.
Futures
price
Cash
price1
Call gain/
(loss)
Put gain/
(loss)
Net
price2
$4.50
$4.40
($0.45)
$0.18
$4.67
$4.60
$4.50
($0.45)
$0.28
$4.67
$4.70
$4.60
($0.45)
$0.38
$4.67
$4.80
$4.70
($0.45)
$0.38
$4.77
$4.90
$4.80
($0.45)
$0.38
$4.87
$5.00
$4.90
($0.35)
$0.38
$4.87
$5.10
$5.00
($0.25)
$0.38
$4.87
Includes -$0.10 basis
Does not include brokerage fees or interest
1
2
Price ceiling
Call strike price
$4.90
Call option premium
+$0.45
Put option premium
-$0.38
Local basis
-$0.10
Price ceiling
$4.87
The primary advantages and disadvantages of
the window strategy are:
Window Advantages
Upside price protection provided by the call
option is less costly because income received from
selling the put option offsets some or all of the cost
of the call option. With the dairy producer’s window, the net cost of the call option is $0.07 ($0.45
- $0.38) as long as the futures price remains higher
than the put strike price.
Floor price
Put strike price
$4.70
Call option premium
+$0.45
Put option premium
-$0.38
Local basis
-$0.10
Floor price
$4.67
Window Disadvantages
The final purchase price of the input commodity
may be higher with a window strategy than when
buying only a call. This is because the window
strategy imposes both a maximum purchase price
and a minimum purchase price.
Selling a put option requires that a margin
account be established.
Before using a window strategy, make sure you
feel comfortable with your knowledge of futures,
options, and margin requirements. A window
strategy is one of many ways to use futures and
options to manage upside price risk. And like all
marketing tools, a window strategy can be useful
if you know how to use it and know the advantages and disadvantages.
Table 3 illustrates the net price paid for the corn
at various futures prices on the option’s expiration date, the day the hedge is lifted. The $4.67
floor price is attained when the futures price is
equal to or below the put strike price. When the
futures price is equal to or higher than the call
strike price, the net price paid is equal to the price
ceiling. When the futures price is between the put
strike price and the call strike price, the net price
of corn is increased or decreased by the amount
of the net premium paid. When the futures price
is equal to or higher than the put strike price, you
keep the entire amount received from selling the
put option.
4
Partial funding support has been provided by the
Texas Corn Producers, Texas Farm Bureau, and
Cotton Inc.–Texas State Support Committee.
Produced by Texas A&M AgriLife Communications
Extension publications can be found on the Web at: http://AgriLifeBookstore.org.
Visit Texas AgriLife Extension Service at http://AgriLifeExtension.tamu.edu.
Educational programs of the Texas AgriLife Extension Service are open to all people without regard to race, color, sex, disability,
religion, age, or national origin.
Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914,
as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Edward G. Smith, Director,
Texas AgriLife Extension Service, The Texas A&M System.